United States: ESOPS Are An Excellent Business Succession

Imagine the scenario in which a business owner spends 30+ years
developing and maturing a successful, privately held business.
After a successful run, the owner, whose children have little
interest in taking over the business, decides to cash out and sell
the business. However, the owner, who is very proud of the business
and the strong positive reputation associated with the
company's name and branding, desires that the company keep its
name and branding in place. In addition, the owner wants to make
certain the company's loyal employees are not harmed by the
sale. So before inking a deal with a private equity firm, the
business owner negotiates certain protections to achieve these
goals—a two-year employment agreement for the owner (the
longest period of time the private equity firm would agree to) and
an agreement that the company must remain in the same facility for
at least three years following the sale. Finally, the business
owner would like to reinvest the proceeds generated by the sale of
the business in marketable securities in a tax-favorable
manner.

Now fast forward to three years following the completion of the
sale of the business. The private equity firm (now owning the
company) has decided to consolidate the company's operations
with another one of its portfolio companies. As a result of this
restruc­turing, the company's products will now be marketed
under a different name, and its operations will be moved to a
location that is more than 300 miles away from the company's
historical operating location. Due to the consolidation of
operations and the related relocation, most of the company's
employees will lose their jobs.

The former owner of the company is powerless to protect the
company's former brand name and employ­ees because she was
forced to retire more than a year earlier, at age 60, when the
private equity firm elected not to extend her employment agreement.
Even though the owner of the company was able to liquidate her
investment in the company through the private equity sale
transaction, she still had to pay capital gains tax on the sale
proceeds. Moreover, two of her other primary objectives have not
been achieved. Most of the compa­ny's employees are now
unemployed, and the company's iconic brand name and identity
have been gobbled up as part of a larger conglomerate.

There is an alternative sale strategy the owner could have
pursued to both monetize her investment in the company in a tax
favorable manner and achieve her other goals. Had this business
owner sold her company stock to an employee stock ownership plan
(an ESOP),1 the above unfavorable outcomes to both
company branding/identity and employees would never have occurred.
In addition, under certain circumstances the business owner could
have deferred the imposition of capital gains tax on the sale
proceeds.

A business owner can monetize his or her capital investment in
the business by selling some or all of the company stock to an
ESOP. Following such a sale, the business owner can still maintain
an active role in the business he or she created, and make certain
its image and brand continue to flourish. Moreover, through such
ongoing involvement, the business owner can maintain and protect
the job security of the company's employees, while also
providing them with a supplemental retirement benefit. As a result
of these factors, empirical data shows that ESOP-owned companies
are more profitable and have lower turnover rates than non-ESOP
companies.2

The best way to demonstrate how a leveraged ESOP transaction
works is by example. Assume a busi­ness owner ( John) is
looking to sell 40 percent of his company (a subchapter C
corporation) to an ESOP for $5 million. Once the company, John and
the ESOP negotiate the terms of the deal, the company will lend $5
million (the company obtains this money from either a commercial
bank, company cash on hand, seller notes or a combination thereof)
to an ESOP in exchange for a promissory note. The ESOP, in turn,
uses the $5 million loan proceeds it just received from the company
and purchases a 40 percent interest in the company's stock from
John. John (under certain circumstances) may be able to avoid
having to pay capital gains tax on the $5 million in sale proceeds.
(The mechanics of this Section 1042 of the Internal Revenue Code of
1986, as amended tax deferral election will be discussed later in
this article.) In addition to monetizing a portion of his capital
investment in the company on a potentially tax-deferred basis, John
still retains majority ownership of, and control over, the
business—something a private equity firm would never
permit.

Since this is not a private equity deal, and John retains
control of the company, there is no risk the company will be
relocated or consolidated into a larger business enterprise, and
employee jobs are also protected. Moreover, the legacy of the
company's name and branding will remain in place.

Under Code Section 404(a)(9), each year the company will make a
tax-deductible contribution to the ESOP so the ESOP can pay its
annual debt service requirement back to the company (remember the
ESOP borrowed the $5 million from the company in exchange for a
promis­sory note). The net cash flow from the company to the
ESOP, and then from the ESOP back to the company, is cash neutral.
In other words, the company is not out of pocket any dollars once
the ESOP effectuates its debt service payment back to the company.
However, this circular flow of funds generates a sizable tax
deduction for the company, which means the company can now pay back
outside bank financing (the company probably borrowed a portion of
the $5 million from a bank) with pre-tax dollars. This results in
tax-advantaged financing for the company. Private equity firms do
not have the advantage of using pre-tax financing in their
acquisitions.

As for the employees, as the $5 million note is paid off (assume
it is a 10-year note), each employee/participant in the ESOP will
receive an allocation of company stock in his or her account,
pursuant to the requirements estab­lished under Treas. Reg.
Section 54.4975-7(b)(8). Here, 10 percent of the company stock that
was purchased by the ESOP is allocated each year to the
participants (in the aggregate). After 10 years, all of the company
stock that was purchased by the ESOP will be allocated to the
participant accounts. Over the years, each participant's
account balance will grow in size and, hopefully, will prove to be
a significant supplemental retirement benefit for the participants.
This ESOP benefit is entirely employ­er paid; there is no cost
to the participant.

Unlike private equity sales, in which the $5 million in sale
proceeds is subject to federal and state capital gains tax, John
has the ability to defer capital gains tax by making a Code Section
1042 election. In order to have tax deferral treatment apply under
Code Section 1042, the following criteria must be satisfied:

1. The company has to be a subchapter C corporation. As of now,
current law does not permit sellers of S corporations to effectuate
a tax deferral election.3

2. The ESOP must purchase qualified employer securities, which
means the stock sold to the ESOP must possess the best dividend and
voting rights of all classes of stock.4

3. The ESOP must own at least 30 percent of the company
following the sale.

4. The stock sold by the owner to the ESOP cannot have been
acquired through the exercise of stock options or under some other
form of employee benefit plan.

5. The selling shareholder cannot participate in the
ESOP.5

6. The selling shareholder must purchase qualified replacement
property (QRP) within three months prior to the sale to the ESOP or
within 12 months after the sale to the ESOP. QRP is essentially
stocks, bonds, debentures or notes issued by domestic operating
corporations. Investments in mutual funds or in foreign
corporations will not qualify as QRP, thereby triggering capital
gains tax.

There are about 10,000 ESOPs currently in place in the United
States, covering over 10 million employees (which equates to about
10 percent of the private sector workforce).6 There are
certain macro factors that support ESOPs in today's economy.
Several of these factors include: 1) baby boomer business owners
are approach­ing retirement age and need an exit strategy; 2)
stock market multiples are at or near record highs; 3)
borrow­ing rates on loans are low; and 4) banks' lending
param­eters have generally loosened in the last few years.

In summary, an ESOP may be a superior business succession
strategy as compared to selling to a private equity firm (or even
certain other types of buyers). The only potential minor drawback
to an ESOP transaction (as opposed to selling to a private equity
firm or other strategic buyer), is that an ESOP, by law, is not
permit­ted to pay in excess of fair market value for company
stock that it acquires. In certain situations (in which a private
equity firm or other strategic buyer thinks it can reap certain
synergistic benefits by combining or consolidating target entities)
certain buyers may be will­ing to pay a premium for a business
owner's company or stock. However, many business owners may be
willing to sacrifice a few extra dollars in sales proceeds in an
ESOP transaction in order to protect the legacy of their company
and to protect and reward their employees. In addition, the tax
savings from a Code Section 1042 election may be sizeable enough to
offset any premium offered up by a private equity firm or other
strategic buyer for the business.

Footnotes

1. An ESOP is a qualified retirement plan.

2. ESOP Association, www.ESOPAssociation.org.

3. On July 19, 2017, the bill entitled the Promotion and
Expansion of Private Employee Ownership Act (S. 1589) was
introduced. This bill, in part, would extend the deferral of
capital gains tax to qualified sellers of subchapter S corporation
stock.

4. Under Code Section 409(l)(3), convertible preferred
stock may be able to qualify as employer securities in certain
circumstances.

5. Moreover and pursuant to Code Section 409(n), any
individual who is related to the selling shareholder (within the
meaning of Code Section 267(b)) cannot participate in the ESOP; and
any other person who owns (after application of Code Section
318(a)) more than 25 percent of (a) any class of outstanding stock
of the corporation or any member of the same controlled group, or
(b) the total value of any class of outstanding stock of any such
corporations, likewise cannot participate in the ESOP.

6. ESOP Association, www.ESOPAssociation.org.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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